Dr.

Duke's Probability Calculator

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Data Input:

Price: $3,223.00
Target Price: $3,050.00
Implied Volatility: 12.57 Enter as a percentage, e.g. 12.45, not 0.1245
Days to Expiration: 23

One Standard Deviation (σ) Move = $101.70

Probability of Stock Price Closing Above the Target Price: 96.0%

Probability of Stock Price Closing Below the Target Price: 4.0%

One σ Above the Current Price: $3,324.70

One σ Below the Current Price: $3,121.30

This calculation is based upon the assumption that stock prices behave according to a normal or
Gaussian distribution (the classic bell shaped curve). Think of today’s stock price as the peak of the
bell shaped curve. The normal price distribution illustrates what we know intuitively, i.e., a larger move
in price to the edges of the distribution curve is less likely. These calculations simply let us quantify
the probabilities of our price estimates. If we were analyzing a stock's historical price behavior, we would
use the stock's historical or statistical volatility in the distribution calculation. Since we are estimating
the stock price movement for the future, we will use today’s implied volatility for the stock's options as the
market's best estimate of the stock's future volatility. Therefore, we can use the implied volatility as an
estimate of the standard deviation for the price distribution calculation. For a normal distribution, the
probability of the data point being contained within plus or minus three standard deviations of the mean
is 99.74%. Similarly, a one standard deviation move in either direction should encompass 68% of the data.

These calculated probabilities are the accurate predictions for a series of random events such as
computing the probabilities of rolling a seven when playing dice. If stock prices behaved as statistically
random events, like flipping a coin, one would expect stock price moves outside of the plus or minus
three standard deviations to be an extremely rare event (only a 0.26% probability). In fact, it isn't. This is
the so-called "fat tails" problem, i.e., the far ends of the distribution are higher or fatter than predicted.

Stock prices are subject to many non-random forces - news events, crowd psychology, etc. Thus, stock
price moves of greater than three standard deviations occur far more often than predicted. Therefore, do not
look at these calculated probabilities as precise predictions of the stock price. But we could expect these
probabilities to be more and more accurate if we were placing similar trades one after another. We can
also use these probabilities to compare the relative risks of various trades. For example, one could
compute the probability of the stock price closing above the sold strike price for a series of potential
covered call trades, and rank them on this basis.

This form of a probability calculator can be used with many different options strategies. For example,
if we are considering an OTM bear call spread on the SPX and want to know which strike prices to use for
a high probability trade, we would enter the current price of the SPX, $1693, the current IV of 13.3%
and 30 days to expiration, and calculate one standard deviation of $64.55 (the Greek letter, sigma (σ), is
traditionally used to signify a standard deviation in statistics; thus, in this example, σ = $65)

Therefore, a bear call spread at 1760/1770 would be over one standard deviation away from the current
price and would have a probability of about 84% of the SPX closing below 1760 in 30 days
(68% for the area of plus or minus one σ, or 1628 to 1758, plus the area below 1628
which has a 16% probability).

One could extend this calculation to an iron condor spread by establishing the bull put spread at
1615/1625. Thus, both spreads are about one standard deviation away from the current price and this
trade has a high probability of success. Using this system over time, one would expect to have winners
about 80% of the time; however, the key success factor is managing the losses the other 20% of the
time. Couple this technique with a solid stop loss discipline for a robust trading system.

For more details and background, see:

Options as a Strategic Investment, fourth edition, Larry McMillan, pages 456-489

Kerry W. Given, Ph.D.

Parkwood Capital, LLC
1/1/20